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The Non-Designation of Derivatives As Hedges for Accounting Purposes Eugene E

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The Non-Designation of Derivatives As Hedges for Accounting Purposes Eugene E The Non-Designation of Derivatives as Hedges for Accounting Purposes Eugene E. Comiskey and Charles W. Mulford The FASB recently issued Proposed Statement of Financial Accounting Standards, Accounting for Hedging Activities: An Amendment of FASB Statement No. 133. The proposed standard simplifies the accounting for hedging activities and generally increases the appeal of hedge accounting. In this report we survey firms’ reporting practices and examine hedges and hedge accounting generally and seek to determine why firms may decide not to designate derivatives as hedges for accounting purposes. In reviewing the reports of a large sample of firms, we find the following four explicit reasons why companies may decide not to designate derivatives as accounting hedges: (1) the substantial cost of documentation and ongoing monitoring of designated hedges; (2) the availability of natural hedges that can be highly effective; (3) a new accounting standard that broadens the applicability of natural or economic hedges; and (4) qualifying hedges are not available or are too costly or documentation is untimely, inadequate, or unavailable. In addition, a fifth reason, not offered as such by the surveyed firms, is the increased risk of restatement that accompanies hedge accounting. The proposed standard combined with the recently-released SFAS 159, The Fair Value Option for Financial Assets and Liabilities, offer companies a welcome relief to the onerous accounting and reporting requirements of SFAS 133. JARAF / Volume 3 Issue 2 2008 / 3 THE JOURNAL OF APPLIED RESEARCH IN ACCOUNTING AND FINANCE Introduction Recently, the Financial Accounting Standards Board (FASB) provide a brief review of the range of hedge designations that issued Proposed Statement of Financial Accounting Standards, can be applied to derivatives and the basic features of hedge Accounting for Hedging Activities: An Amendment of FASB accounting applicable to these designations; section (2) out- Statement No. 133.1 The purpose of the proposed standard is lines important nomenclature associated with hedges that are to amend accounting for hedging activities in FASB Statement achieved with or without the use of derivatives and/or hedge No. 133, (SFAS 133), Accounting for Derivative Instruments accounting; in section (3) examples of firms that employ and Hedging Activities.2 Among its provisions, the proposal derivatives for hedging purposes but do not designate them for seeks to simplify the accounting for hedging activities. To- hedge accounting are provided; section (4) identifies appar- ward achieving this objective, the proposed standard would ent reasons for the non-designation of derivatives; section (5) a) lessen the effectiveness threshold necessary for applying provides illustrations of the influence that the non-designation hedge accounting from highly effective to reasonably effec- of derivatives can have on earnings, and section (6) summa- tive at offsetting changes in fair value or variability in cash rizes the study’s results and provides observations on future flows and b) require an effectiveness evaluation at inception developments for hedge accounting. of the hedging relationship, though after inception, an ef- fectiveness evaluation would be required only if circumstances suggest that the hedging relationship may no longer be reason- ably effective. 1. Derivative Designations and Associated Accounting A key purpose of hedge accounting is to reduce earnings vola- A derivative not designated for hedge accounting is carried tility by recording in earnings in the same time period a gain on the statement of financial position at its fair value. The or loss on a hedged item and the loss or gain on the related gains and losses associated with the changes in the fair value hedge. With hedge accounting, whether a gain or loss on the of these derivatives are included in the income statement as hedged item is recognized currently or deferred in accumu- they occur. However, derivatives that meet the requirements lated other comprehensive income, an offsetting loss or gain of SFAS No. 133 may be designated as accounting hedges. The on the hedge is recognized in a similar way. For example, designations of derivatives for accounting purposes are either with hedge accounting, a loss arising from a forward contract as fair-value hedges or cash-flow hedges. to sell Yen would be recognized in earnings along with a gain on an underlying Yen-denominated receivable. Similarly, a Fair-value hedges gain on an interest rate swap used to hedge variable rate date and effectively convert it to a fixed rate obligation would be Derivatives used to hedge the fair value of recognized assets deferred in accumulated other comprehensive income as no and liabilities or firm commitments are referred to as fair- loss would be recognized currently on the underlying debt. value hedges.4 The effectiveness of the hedge is based upon The matching of gains and losses in this way is a desirable the extent to which the gain or loss on the derivative offsets outcome, but one that is not achieved if the criteria of SFAS the loss or gain on the hedged position. With a perfectly ef- 133 are not met. Under SFAS 133, however, such accounting fective hedge, the gains and losses on the derivative and the treatment requires that the hedge is highly effective in offset- hedged position exactly offset each other and are recognized ting specifically identified risks and that the effectiveness of in the same reporting period. Such a result shields earnings the hedge is monitored regularly after inception. Such criteria from the volatility that would otherwise result from changes are often difficult to meet, resulting in the non-application in the underlying of the derivative, e.g., a foreign currency of hedge accounting and a mismatch of gains and losses on rate, an interest rate, the price of grain, etc. Any difference hedged items and their related hedges and the potential for between the gain or loss on the derivative and the loss or gain increased earnings volatility. on the hedged item is referred to as hedge ineffectiveness and is recognized currently in earnings. By simplifying the requirements, the proposed amendment of SFAS 133 seeks to broaden the appeal of hedge accounting. The accounting for a perfect fair-value hedge of an asset with The implication is that at present, due to the complexities of a derivative is outlined below. Assume that the value of an SFAS 133, firms who might otherwise apply hedge accounting equity security held for trading purposes is hedged with the for derivatives transactions may not be doing so. It would purchase of a put option. The gain on the hedge and the loss seem, however, that there may be other reasons apart from on the investment are each assumed to be $1 million. If there the complexities of SFAS 133 that may lead firms to decide not were some ineffectiveness with the hedge, this difference to apply hedge accounting. would be included in the income statement. The purpose of this study is to examine hedges and hedge ac- (1) Recording the decrease in the fair value of the hedged counting generally and to explore decisions made by firms not asset to designate derivatives as accounting hedges. The study is motivated in part by the observance of numerous cases where a. Loss of $1 million from the decline in the value of firms employ derivatives that work well as economic hedges, the trading security but where the derivatives are not designated for hedge ac- b. Decrease in the fair value of the trading security by counting. The end result may be increased earnings volatility. $1 million There is a cost associated with increased earnings volatility in the form of a potential reduction in firm value.3 However, (2) Recording the increase in the fair value of the derivative there are also costs associated with the documentation and a. Increase of $1 million in the fair value of the put monitoring required for qualifying and sustaining a derivative option for hedge accounting. What we seek to determine is whether the complexities of SFAS 133, and the related costs, appear b. Gain of $1 million from the increase in the fair to be prominent in the firms’ decisions not to employ hedge value of the put option accounting. Note that the loss on the hedged asset in (1a) is perfectly The outline of this report is as follows: in section (1) we offset by the gain on the derivative in (2b). 4 / JARAF / Volume 3 Issue 2 2008 The Non-Designation of Derivatives as Hedges for Accounting Purposes Cash-flow hedges to hold these instruments because, “It believes they continue to represent good economic hedges in its goal to minimize jet Cash-flow hedges result when derivatives are employed to fuel costs.”8 hedge “. the exposure to expected future cash flows that is attributable to a particular risk. That exposure may be as- Foreign currency hedges sociated with an existing recognized asset or liability . or a forecasted transaction . .”5 Unlike the fair-value hedges, The accounting for foreign-currency hedges is treated sepa- 9 where offsetting gains and losses are recognized on a contem- rately in SFAS No. 133. When the hedged item is in a foreign poraneous basis, this ongoing symmetry (within the income currency, the hedge may be designated as, (1) a fair-value statement) of recognized gains and losses is not present with hedge in the case of unrecognized firm commitments and a cash-flow hedge. As a result, the effective portion of gains recognized assets and liabilities; (2) a cash-flow hedge in the and losses on the derivatives are initially recorded in accumu- case of forecasted transactions, including cash flows associ- lated other comprehensive income (i.e., shareholders’ equity). ated with recognized assets and liabilities, and unrecognized These accumulated gains and losses of the derivative are sub- firm commitments; and (3) a net investment hedge in the case 10 sequently reclassified into the income statement “.
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